Sometimes the leaser can make better use of depreciation tax shield generated by an asset than the asset user. It may make sense therefore for the leasing company to own the equipment and pass over some of the tax benefits to the lessee in form of low lease payments.
In markets that are efficient, the following reasons are usually given are ―Dubious‖ reasons for leasing (i) Leasing Is An Off Balance Sheet Financing
When a firm obtains off-balance sheet financing, the conventional measures of financial leverage such as the debt equity ratio understate the true degree of financial gearing.
Some people believe financial analysis do not always notice off balance sheet lease obligation (which are still referred to as foot note) or the greater volatility of earnings that result from fixed lease payments. Note that in an efficient market, price would reflect all the available information including the lease obligation.
(ii) Leasing Avoids Restrictive Covenants
When a company borrows money it must usually consent to certain restrictions on future borrowing. If the bond indenture does not include any restriction on leasing then leasing can be seen as a way of avoiding restrictive covenants. Note that loopholes such as this are easily stopped and most debt indentures include limits on leasing.
(iii) Leasing Affects Book Income
A lease which qualifies as off-balance sheet financing affects book income in one way. The lease payment are an expense. If the firm buys the assets instead and borrows to finance it, then both depreciation and interest expenses are deducted. Leases are usually set up so that payment in the early years is less than depreciation and interest under the buy and borrow alternative. Leasing therefore increases book income in the early years of an asset life. The return on investment would increase more because the book value of assets (the denominator is understated).
ROI = Capital Turnover x Profit Margin or Reserves x Incomes Investments Reserves or Income
Investments Note;
Leasing impact on book income should not in itself have any effect in firms value in efficient capital market.
(iv) Leasing Avoids Capital Expenditure Control
In some companies, lease proposals are not subject to the elaborate capital expenditure approval procedures needed to buy an asset. This may be important in the public sector e.g. a public hospital may find it easier to lease medical equipment that to ask the government to provide funds for purchase.
Note: Bypassing such controls may result in poor investment decision on the part of the company.
(v) Leasing Preserves Capital
Leasing companies provides 100% financing. They advance the full cost of the lease asset. It may be argued therefore that leasing preserves capital allowing the firm to save its cash for other things.
Illustration:
ABC Ltd has decided to acquire a piece of equipment costing Shs 240 000 of five years. The equipment is expected to have no salvage value ate the end and the company uses straight-line depreciation method on all it Fixed Assets. The company has two financing alternative methods available, leasing or borrowing.
The loan has an interest rate of 15% requiring equal-year-end installments to be paid. The lease would be set at a level that would amortize the cost of equipment over the lease period and would provide the lessor with a 14% return on capital. The company‘s tax rate is 40%.
Required:
a. Compute the annual lease payments.
b. Compute the PV of the cash out flow under lease financing c. Calculate the annual loan installment payment
d. For each of the 5 years, calculate the interest and the principal component of the loan repayment.
e. Calculate the PV of after tax cash flow under the loan alternative f. Which alternative is better and why?
Solution:
a) 240 000 = A + A PVAF 14%, 4 years 240 000 = A (1 + 2.9137)
A = 240 000 = Shs 61, 323 3.9137
b) Year Lease payments Lease Rental Net Payments PVIF 14% PVs Tax shield (40%)
0 61 323 - 61 323 1.000 61 323
1 61 323 (24 529) 36 794 0.9174 33 755
2 61 323 (24 529) 36 794 0.8417 30 970
3 61 323 (24 529) 36 794 0.7722 28 412
4 61 323 (24 529) 36 794 0.7084 26 065
5 61 323 (24 529) (24 529) 0.6499 (15 941) Total PV‘s 164 584 c) Annual Loan Installments
240 000 = A PVAF 15%, 5 years A = 240 000 = Shs 71 595
3.3522
d) Loan Amortization Schedule
Year bal. at Installment Interest Principle Outstanding Bal. the beg.
1 240 000 71 595 36 000 35 595 204 405 2 204 405 71 595 30 661 40 934 163 471 3 163 471 71 595 24 521 47 074 116 397
4 116 397 71 595 17 460 54 135 62 262 5 62 262 17 595 9 339 62256 6*
* rounding off error
Depreciation of the asset = 240 000 – 0 = 48 000 5
e) Year Depreciation Interest Total Tax shield (40%) Cash flows PVIF 9% Pv‘s (71595-tax)
1 48 000 36 000 84 000 33 600 37 995 0.9174 34 857
2 48 000 30 661 78 661 31 464 40 131 0.8417 33 778 3 48 000 24 521 72 521 29 008 42 587 0.7722 32 886 4 48 000 17 460 65 460 26 184 45 411 0.7084 32 169 5 48 000 9 339 57 339 23 936 48 659 0.6499 31 623
165 313
f) Decision:
Leasing is better than borrowing because it‘s cheaper and results in lower cost of transaction.
N.P.V of leasing = 240 000 – 164 584 = Shs 75, 416 N.P.V of borrowing = 240 000 – 165 313 = Shs 74 687
Net benefit of leasing 729
9.6 SALE – LEASE BACK ARRANGEMENT
This is a transaction involving the simultaneous sale of an asset and the leasing back of the property to the seller by the purchase for a long term (long period of time). The sale-lease back can be traced back to early 1940‘s in America.
It occurred due to:
Institutional investors were limited by state laws to loan to value ratio of 66% to 76%. A method was required which was legal and would increase the amount of money that could be loaned against real estate security.
Corporations had large sums of money tied up in real estate and were anxious to put those funds to work in a more advantageous and active way. The sale lease back technique therefore appeared as an alternative to mortgage and as a means of increasing the amount of financing available for any single real estate transaction. It also presented a feasible and workable method of exchanging ownership but not possession for costs. It also provided a way of financial institution continuing to lend even when they have exhausted that lending limit.
There are 2 types of sale lease back arrangements. These are:
1 Prime Credit Transaction
In this case the tenant is a large and prominent corporation and in the past has conducted a number of sales lease back transaction e.g. a petrol station with a sale lease back with an oil company.
In such a transaction 100% financing is usually available since the purchaser is entering the transaction on the basis of the seller‘s credit rating but not the value of the asset.
2 Reality Transaction
Here the purchaser (the leasor) is investing on the basis of the property without much regard for the seller (lessee) credit status. The asset must therefore be a general-purpose asset. Usually the purchase price is about 80% to 90% of the property‘s value rather than 100%.
10.0 OPTIONS
An option is a contract which gives its holder the right to buy (or sell) an asset at some predetermined price within a specified period of time. Pure options are instruments that
(a) Are created by outsiders rather than the firm (usually investment bankers) (b) Are bought and sold primarily by investors
(c) Are of greater importance to investors than to financial managers 10.1 TYPES OF OPTIONS
(a) Call Option
A call option gives the holder the right to buy an asset (or security) at a specified price (exercise price or striking price) within a specified period (exercise date). The seller is called a writer.
An investor who writes a call option against securities held in his portfolio is said to be selling covered options. Options sold without the stock to back them up are called naked options.
When the exercise price exceeds the current stock price, the option is said to be out-of-money. When the exercise price is less than the current price of the underlying stock, the option is said to be in-the-money.
(b) Put Options
An investor can also buy an option which gives him/her the right to sell a security at a specified price within some future period. This is called a put option.
10.2 FACTORS THAT AFFECT THE VALUE OF A CALL OPTION (a) The market price of the underlying shares.
The higher the share price, the higher will be the call options price.
(b) The higher the striking price, the lower will be the call option's price.
(c) The longer the option period, the higher will be the option price because the longer the time before expiry, the greater the chance that the stock price will increase substantially above the exercise price.
Theoretical value = Current market — Exercise Price of option (Expiry Value) price per share
E.g.
If a share has a market price of Sh 50 and its option has an exercise price of Sh 40 then the value of the warrant is Sh 10.
The minimum value of an option which is out-of-money is zero. The value of a call option can be shown by the following graph:
Option premium = Market Price — Theoretical value
of option of option
10.3 THE BLACK AND SCHOLES OPTION PRICING MODEL (OPM) This model was developed in 1973 and, it has the following assumptions:
Assumptions
1. The stock underlying the call option provides no dividends or other distribution during the life of the option.
2. There are no transaction costs in buying or selling either the stock or the option.
3. The short—term, risk free rate is a known constant during the life of the option.
4. Any purchaser of a security may borrow any fraction of the purchase price at short—term risk free interest rate.
5. Short selling is permitted without penalty and the short seller will receive immediately the full cash proceeds of today's price for a security sold short.
6. The call option can be exercised only on its expiration date (European option).
Trading in all securities takes place in continuous time and the stock prices move randomly in the continuous time.
The model can be given by the following formulas
Where V = Current value of option with time t until expiration P = Current price of the underlying stock
N(d1) = Probability that a deviation less than d1 will occur in a standard normal
t = time until the option expires (the option period) Ln P/X = natural logarithm of P/X
δ² = Variance of the rate of return on the stock The value of an option is therefore a function of
(a) P the stock price
(b) t the options time to expiry (c) X the exercise price
(d) δ² the variance of underlying stock (e) KRF the risk free rate
Illustration
Assume that the following information has been obtained:
P = Sh 20
X = Sh 20
t = 3 months (0.25 years) KRF = 12%
δ² = 0.16
Determine the value of the option
d )]
Solution:
d1 = Ln (20/20) + [0.12 + (0.16/2)] 0.25 0.4 0.25
= 0 + 0.05 = 0.25 0.2
d2 = d1 - 0.20 = 0.05
N(d1) = N(0.25) = 0.5987 Using the standard normal table N(d2) = N(0.05) = 0.5199
V = 20(0.5987) — 20e-(0.12)(0.25)(0.5199)
= 20(0.5987) — 20(0.9704)(0.5199)
= 11.97 — 10.09
= Sh 1.88
10.4 APPLICATION OF OPTION PRICING MODEL
The equity of a levered firm can be thought of as a call option. When a firm issues debt it is equivalent to the shareholders selling the assets of the firm to the debtholders, who pay for the assets with cash plus an implied call option whose exercise price is equal to the principal value of the debt plus interest. If the company is successful, the stockholders will buy the company back by exercising their call option and thus paying the principal and interest on the debt. Otherwise stockholders will default on the loan, which amounts to not exercising their call option and thus giving the company to the creditors.
Illustrations
ABC Company is being formed to make a 1 year investment in producing and marketing presidential campaign badges. The firm requires an investment of Sh 10,000,000 of which Sh 7,500,000 will be obtained by selling debt with a 10% interest rate and the other Sh 2,500,000 will be raised by selling common shares. All cash distribution to debt holders and shareholders will be made at the end of the one year. After this year is over the value of the firm will depend primarily on which candidates make it through the primary elections. The estimated probability of distribution of the firm is:
Probability Value `000' 0.7 20,000 0.2 5,000
0.1 0
Consider the shareholders value under the three states of nature and under the expected value.
Solution:
Expected value of the firm = 0.7(20,000) + 0.2(5,000) + 0.1(0) = Sh 15,000 Sh`000' Sh`000'
Expected Value 15,000
Less
Debt principal 7,500
Interest 750 8,250
Value to shareholders before taxes 6,750
If value is Sh 20,000,000
Sh`000'
Value of the firm 20,000
Less debt principal and interest 8,250
Shareholders value 11,750
Sh`000' If value is 5,000
Value of the firm 5,000
Less Debt Principal and Interest 8,250
Shareholders value (3,250)
Sh`000' If value is 0
Value of the firm 0
Less Debt principal and interest 8,250
Value to shareholders (8,250)
Under the value of Sh 5,000 and 0 the shareholders will not buy the company back and therefore the actual value will be zero but not negative.
11.0 DIVIDEND THEORY AND DECISION
Dividend policy determines the division of earnings between payments to stockholders and reinvestment in the firm. This section, therefore, looks at:
(a) How to pay dividend (b) When to pay dividend (c) How much dividend to pay (d) Why dividend is paid
11.1 DIVIDEND PAYOUT DECISION
In principle, a company is supposed to pay cash dividends but under financial constraints or otherwise, it can pay stock dividends.
A stock dividend is paid in additional shares of stock instead of cash and simply involve a bookkeeping transfer from retained earnings to ordinary share capital.
Payment of stock dividend has already been considered in Section 7.2.5.
The company can buy back some of its outstanding shares instead of paying cash dividend. This is known as stock repurchase and shares that have been bought back are referred to as treasury stock. If some outstanding share are repurchased, few shares will remain outstanding and assuming the repurchase does not adversely affect the firm's earnings, the earning per share of the remaining shares will increase. This increase may result in a higher market price per share, so capital gains will be substituted for dividends.
Stock repurchase has the following advantages:
(a) It may be seen as a positive signal because the repurchase may be motivated by management's belief that the firm's shares are undervalued.
(b) The shareholders has a choice to sell or not to sell. On the other hand, one must accept a dividend payment and pay tax.
(c) The repurchase reduces the number of outstanding shares and thus increases the market price per share.
(d) The firm can use repurchased stock when stock options are exercised.
(e) A company may use repurchased stocks to undertake a major restructuring such as changing its capital structure.
(f) A company can repurchase its shares to make it impossible for the company to be acquired.
However, stock repurchase has the following disadvantages:
(a) The selling shareholders may not have all the information about the firm and thus may sell their shares at a lower price.
(b) If the shares are not actively traded in the market, the company may offer a price which is above equilibrium. This reduces the wealth of remaining shareholders.
11.2 ALTERNATIVE DIVIDEND POLICIES
There are four major dividend policies that can be followed by a firm. These are:
(a) Constant amount of dividend per share
Under this policy a company will pay a fixed amount per annum per share regardless of the fluctuations in its profits. Dividends are increased only after an increase in earnings appear clearly sustainable and relatively permanent. The following graph can show this policy:
(b) Constant payout ratio
Under this policy, the firm will pay a fixed dividend rate (e.g. 10% of earnings). The dividend per share would therefore fluctuate as the earnings per share changes. This policy can be shown by the following graph:
(c) Constant dividend per share plus extras
This is a compromise between the two policies discussed above. It gives the firm flexibility to increase dividend during years of high earnings. The extra dividend is given to the shareholders in such a way that they don't perceive it as a commitment on the part of the company to continue this extra dividend in the future. This policy can be shown as follows:
(d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment decisions have been financed. Dividend will only be paid if there are no profitable investment opportunities available. This policy is consistent with shareholders wealth maximization objective.
Note: The student should look at the advantages and disadvantages of each of the above policies.
11.3 DIVIDEND THEORIESThere are several theories which try to look at the relevancy or irrelevancy of dividend payment. We shall discuss some of these theories: